Europe merely one of the potential powder kegs this week?

The European sovereign debt crisis is the main focus at the moment – but what if it is just one powder keg in a room full of others?

A great column on the challenges facing the EuroZone from the FT's Wolfgang Munchau here over the weekend (Zero Hour for the Euro) describes how "on a purely technical level, the Euro Zone crisis can still be solved", but that the root of the problem is one of political will - can the Euro Zone politicians and all member countries work together with sufficient cooperation and speed to get ahead of the curve – and as Munchau states, “even if Europe’s leaders were to come together tomorrow and agree on all the necessary steps to end the crisis, they would not have solved it until they could demonstrate that they enjoyed full political support.”

After all, the promises to do something at the recent G-20 notwithstanding, we've still got the spectacle of infighting over the EFSF expansion and Greek bailout from over two months ago that has yet to be approved or implemented. Meanwhile the problem has migrated to the threat of a full core meltdown as Italy is already in dire straits and France seems not far behind. Time has run out and the market knows that and issued its strong warning last week.

But while the situation in Europe is the almost all-consuming main plot and European politicians are likely going to step up with a new level of response to the problem (though the market is still leading them by the nose and uncertainty remains how a new bailout framework would sit on the domestic front once it is attempted), there are a couple of other menacing subplots in the background.

These subplots were laid bare by the UBS rogue trader affair – the systemic risk induced by violent market moves. At UBS, one loan trader fiddling with derivative instruments with inherent risk he obviously underestimated, destroyed the bank’s entire quarterly profit, apparently on a Swiss franc bet that soured in the face of the SNB’s massive step intervention.

This last week, key markets that have receive intense macro focus over the last few quarters went haywire: gold tumbled a vertigo-inducing 175 dollars, silver lost 10 dollar an ounce and copper fell about 75 cents a pound – it’s worst week, since, well, ever. In currencies, USDMXN, to take a prominent example from the emerging market segment, traded a 115 big-figure range. It was also a week that saw Goldman Sachs announced it was halting its Global Alpha hedge fund due to disappointing results – you know it’s time to be scared when even the “evil empire” can’t make a dime on macro themes. After the tremendous volatility this week, the CME also bumped its margin requirements higher over the weekend, which could squeeze leveraged longs even more.

The point is, imagine what kind of carnage these kinds of moves might be inflicting on derivatives portfolios out there across the hedge fund and prop trading universe and the potential for further emergency liquidation if this doesn’t soon reverse. And on that front – consider the flawed idea of the zero sum in OTC derivatives (great Zero Hedge piece on this over the weekend that explains the dangerous assumptions related to “bilateral netting”. A basic example that gets to the heart of the problem is this – let’s say gold is trading 1900/oz. and I buy a 2-week, 1700-dollar put that someone is willing to write me for 1 dollar an ounce, since it looks like sure money considering the enormous distance to the strike price. I’m a big player so I buy USD 100 million notional – i.e., I have the right to sell 100 million ounces of gold at 1700/oz. at the expiry date. In the world of “zero sum” there is no net risk to the market as the two transactions “net out”. But if gold drops to 1500/oz. over those two weeks, we have suddenly created the need for a USD 20 billion payout for my options. That’s the kind of danger lurking out there – that these moves don’t just nix a large bank’s profits for a quarter, but that they render a large player completely insolvent and/or set off a chain reaction. (The reason the US decided it had to bail out AIG.)

More specifically on the copper front, imagine what kind of damage the fall in the copper price is doing to the copper-based collateral credit market in China – could this move induce emergency selling of millions of tons of copper and create a new round of financial havoc in China.? The market is rather opaque, but the outlines of the situation have been clear enough from various corners that something obviously went “snap” last week when copper pushed through 3.90/lb. Stay tuned.

This piece is not intended to induce panic, but merely to hopefully show the potential dangers lurking at the moment, not just from the Euro sovereign debt crisis – but the fact that it may be just one powder keg in a room full of other kegs – setting one off can instigate a financial chain reaction.

Now, more than ever, stay very careful out there until the dust settles.

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